Intermediate Microeconomics and Its Application 12th Edition by Walter Nicholson,Christopher Snyder

Exercise 21

Consider the moral-hazard problem that arises when a risk-averse manager, whose effort is unobservable, runs a firm on behalf of shareholders. Explain how the trade-off between incentives and risk prevents the firm from obtaining the fully efficient outcome. How can the moral-hazard problem be eliminated if effort is observable? How can the moral-hazard problem be eliminated if effort is unobservable but the manager is risk neutral?